Confused by the sub-prime crisis? Understanding what happened requires visiting three myths.
Housing prices never drop: In 1997, inflation-adjusted housing prices were close to their previous 50-year baseline average, but by 2007 they had doubled. In 2008 the bubble burst and with any luck prices will bottom out at 2004 price levels in 2009. The good news is that most people remain in a home 10 years so on average: if you bought before '04, you are still in the money, if you bought in '04 you'll break even in '09, and if you bought after '05 you have the next 7½ years to recover.
Securitization eliminates risk: Securitization is to bankers what sausage is to butchers, in that neither likes talking about what's inside. Mortgage bankers wrote "liar loans" - no job, no income, no credit, no money down, no problem - because they knew that housing prices never go down. Then they stuffed these entrails - excuse me, securitized these sub prime loans - into sausage - whoops - I mean into collateralized debt obligations which were sold off to "smart money" buyers on Wall Street who resold them to investors all over the world.
Government regulators know what they are doing: I have tremendous respect for Alan Greenspan, but truth be told the Fed's focus on nursing the economy back from 9/11 with cheap money went on far too long and laid the foundation for the low rate adjustable rate mortgages, predatory lending, speculation and buyer stupidity that created this mess.
The sub-prime market is maybe 5 percent of the total mortgage market and six months ago maybe a third to half of these loans were showing signs of stress. Out of this 2.5 percent, another third to half were likely to end in foreclosure, so it was reasonable to expect that up to 1.25 percent of the market could default - slightly above normal - so no big deal. Here's what I missed.
The reason housing prices doubled between 1997 and 2007 was that the Fed's cheap money fueled a meth-lab for mortgages that created a demand bubble for housing. Once interest rates began to rise and ARMs began to adjust, the house of cards began defaulting faster than normal, causing a steep drop in prices.
With Myth No. 1 fading, holders of "securitized sausages" began worrying about the quality of their CDOs. To their dismay, they discovered they would be eating most of them - but nobody could say exactly how much botulism had found its way into any particular sausage - so CDO markets froze and values evaporated.
It turns out that banks had been big buyers of CDOs, which is about the worst possible place they could have landed because banks are "leveraged intermediaries," which means that 99 cents of every dollar on their books belongs to somebody else - namely depositors. This means even small losses quickly lead to insolvency, and we are looking at around $200 billion in losses.
In the end, the Fed will pump enough taxpayer money into the financial system to give housing prices time to stabilize. The really sad thing is that we will emerge from yet another self-inflicted disaster none the wiser. Ironic that it was Greenspan who coined the phrase, "There is no such thing as a free lunch."
Rich Shields of Scottsdale teaches economics at the Keller Graduate School of Management.